Nick's Portfolio Tournament: Sweet Sixteen

The Sweet Sixteen games are in the books. Looking at the Elite Eight match-ups, who're your Final Four picks?

Wow. Apparently March Madness has spilled over into April. I was hoping for some calm in the markets so I could focus on this tournament project, but this market seems to always have some sort of significant headwind that requires my attention. A few weeks ago it was the Facebook data scandal that led to a sell-off in the popular F.A.N.G. space. Well, those stocks have seemed to stabilize a bit, but now we’re hearing rumors of an impending trade war with China, which would pose a real threat to the ongoing health of the bull market if the war was to come to fruition and most recently, there geopolitical threats revolving around Syria and Russia have popped up. So, while this potential trade war has very little to do with this NCAA style tournament, work related to it has taken up the lion’s share of my time recently, which is why the rounds of this series are moving along so slowly. Thankfully, I found some time this afternoon to get to work on the Sweet Sixteen. The NCAA tournament is over. Congrats Villanova Wildcats fans! I visited Nova in high school and considered running track there before committing to U.Va and I grew up playing baseball with Howie Long’s kids and I have a lot of love for that family, so I suppose if my Cavaliers couldn’t win, I’m happy to see the Wildcats get their second championship in three years. Now, you just have to hope Jay Wright doesn’t leave for Phoenix to coach the Suns next year. So without any more blabbing on my part, let’s get into the “games”.

1 AAPL vs. 4 JNJ

This is a couple of real heavy weights matched up here. Apple has the largest market cap in the world at ~$850b and Johnson and Johnson has the largest market cap in the healthcare sector at ~$340b. Incredible market caps aside, both companies face potential issues. Apple’s biggest critique in the idea that this company is a “one trick pony”, too reliant on the iPhone. Hardware companies in general are typically given some of the lowest multiples in the tech space because of the idea that their products are commoditized and ripe for disruption. Apple is a 1 seed in this tournament because it is my largest individual holding, meaning that I’ve obviously been willing to look past these bearish notions regarding hardware, instead focusing on the strength of AAPL’s balance sheet, the growth of its services segment, and the likelihood that this company will continue to give shareholders generous shareholder returns. I fully expect to see AAPL become a dividend aristocrat in a couple of decades and I wouldn’t be surprised if the company posted a double digit dividend CAGR during that streak. I think AAPL’s cash/cash flows enable it to evolve over time in the highly volatile tech space; no other large cap in the world has the ability to totally re-invent itself, if need be, than AAPL does. With all this talk of shareholder returns, it seems ridiculous to overlook Johnson and Johnson. Unlike AAPL, JNJ is an established dividend growth powerhouse with 55 consecutive years of dividend growth and a dividend growth CAGR of over 10% dating back 19-years to 1999 (I’m sure this company’s long-term dividend CAGR is even more impressive, I just couldn’t find data regarding more long dated dividend growth data. With that being said, JNJ’s dividend growth has slowed noticeably lately and I suspect the company’s dividend growth rate will continue to shrink due to the maturity of the company. While AAPL’s short-term issues revolve around iPhone cycles and unforeseen disruption, JNJ’s come in the form of patent cliffs, strong competition in the most lucrative areas of the medicine, and potential litigation. I recently trimmed my JNJ position from overweight back to full on news of the asbestos case going against then in New Jersey. I like JNJ, but I don’t feel comfortable owning so many shares of a company with a potentially large headwind. Sure, there are appeals and settlements that could drastically reduce the harm that continued talc related litigation does to this company’s reputation and balance sheet. JNJ’s legal team is well versed in dealing with these issues, but at the end of the day, I think AAPL’s growth prospects are greater and its downside risks are lower moving forward, making it the clear choice to advance to the Elite Eight.

10 JD vs. 11 BIP

This is a true underdog match up. JD is an under seeded growth play with extremely high upside and BIP faced off against Facebook (FB) shortly after the Cambridge Analytica scandal was announced. Other than the fact that these two companies possess similarly low seeds, they aren’t very similar operations. With that being said, I think both companies have strong secular tailwinds behind them in the form of the emerging Chinese middle class and the continued shift from physical stores to eCommerce when it comes to consumption for JD and the necessity for global infrastructure improvements and modernization for BIP. Although I’m bullish on both of these growth markets, I think that JD’s path towards a much larger market cap is more speculative than BIP’s. JD faces very strong competition in eCommerce space and while I think it has the potential to carve out a significant chunk of the Chinese and global market share, I think we’re in such early innings in the global transition away from the brick and mortar model, picking long-term winners and losers outside of the already dominant players (Alibaba (BABA) and Amazon (AMZN)) becomes difficult. While I don’t believe that BIP offers nearly the same upside potential as JD, I do think its path towards posting double digit annual returns for investors is much clearer. Capital shouldn’t be an issue for BIP, which has a powerful parent company in Brookfield, if BIP’s management team’s pursuit of attractive value in the infrastructure space. BIP owns a wide variety of assets across the infrastructure arena, which gives management a lot of flexibility when it comes to purchasing beaten down assets. BIP’s management has highlighted plans to invest further in the data center and water municipality space; I’m especially bullish on the potable water industry (supply is limited and demand will continue to rise alongside population). The differentiating factor of this match up wasn’t the business prospects of either company, but the dividend (or lack there of, when it comes to JD). Right now, I’m in a pretty risk-off mood, when when looking at these two names side by side, BIP’s reliably growing 4% yield put them over the edge.

1 T vs. 12 UTX

It comforts me to see a twelve seed still alive in my tournament; when twelve seeds advance in Cinderella fashion, all seems well in the world. However, unfortunately for United Technologies, their time at the ball is about to end. Don’t get me wrong, I really like UTX. If you’ve followed my writing/investing at all you should know by now that I am extremely bullish on the aerospace industry. UTX has solidified itself as a long-term leader in this space with its recent $30b acquisition of Rockwell Collins. I’m very happy to own the UTX shares that I do and its on my watch list because I’d love to increase my position, just not at its current valuation. At ~17.5x forward earnings, I don’t think UTX is necessarily expensive, but I’m also not excited about paying that premium for a cyclical company in what appears to be a late cycle environment, regardless of how bullish I am on the long-term prospects of the company or its industry as a whole. UTX’s growth hasn’t been as historically lumpy as other large cap industrial names, but it remains a cyclical company and relies on economic growth to grow more so than many of the other companies that I own. AT&T, on the other hand, is about as ingrained into the modern digital age as any company could be. Imagine a day without a smart phone…or worse, with a smart phone, but without data to use it. AT&T carries a ton of debt which is concerning for many potential investors, but the company’s cash flows are massive and very reliable. These reliable cash flows help to pay a 5.6% divided yield which is more than twice the size of UTX’s ~2.3% yield. I fully expect UTX’s dividend growth to outpace AT&T’s in both the short-term and the long-term, but even so, it will take quite some time for it to catch up to T’s, especially if dividends are re-invested over time. I admit that a lot of the bullish sentiment that I hold regarding AT&T’s future growth surrounds the Time Warner acquisition that is currently being decided in the court room, but assuming that AT&T is allowed to vertically integrate content into its current business model, I think this company presents investors with a strong dividend yield and capital gains potential. I’m still bullish on T without the TWX deal, though I have to admit that the prospects of adding top notch content to AT&T’s pipes has caused me to increase the size of my position drastically. I have to believe that the precedent behind vertical mergers will hold true and AT&T will win this case. Because of this (and UTX’s elevated valuation) I’m going to stick with the top seed in this match up

6 INTC vs. 7 BABA

This is a pretty interesting match up of classic “old tech” versus “new tech”. I’m going to be honest, INTC barely squeaked by MSFT due to valuation concerns regarding the latter, and it’s not going to escape BABA’s growth potential. For a second there early last week I thought INTC might have a chance to pull this upset as its shares sold off drastically on the news that Apple was going to phase its chips out of its production; however, when the market realized that this wouldn’t have a significant impact on INTC’s business, shares bounced back in short order. If INTC would have continued to sell off down towards the February lows in the low $40’s, the combination of value, income, and growth prospects might have been enough for it to overcame BABA, but at ~$50/share, I don’t think the margin of safety is quite as wide. Even at $50, INTC is trading at 14x earnings. This relatively cheap calculation is why this company has advanced this far, but as attractive as a 14x multiple is, it doesn’t trump the 20-30% long-term annual growth prospects that I see out of Alibaba. What’s more, BABA has sold off strongly in recent weeks on the trade war fears and honestly, I think this move has been a fairly irrational one by the market. The U.S. isn’t one of BABA’s primary markets and while I’m sure a trade war could potentially hurt the company indirectly, I don’t see the damage as being meaningful, in either the short or long-terms. If I had to guess, I’d assume that the Chinese government would do everything in its power (which is much greater than the U.S. when it comes to company/market manipulation) to prop up its well known technology names like Alibaba. BABA remains a speculative holding for me, but its growth potential is undeniable. Because of this, BABA advances to the Elite Eight to face off against AT&T in a classic match up of income versus growth.

8 TCEHY vs. 5 CMCSA

The last match up between BABA and INTC was a somewhat simple decision to make since it was more of an apples to apples comparison between two companies operating in the same sector. This match up between an American and a Chinese powerhouse isn’t quite as simple. Both Tencent and Comcast operate in the media/entertainment space, so there is that overlap, but there are a lot of dissimilarities as well. I recently wrote an article at Seeking Alpha describing Comcast as one of the best DGI companies out there. Shares are cheap, at ~13.5x earnings, they offer a 2.2% dividend yield, and dividend growth prospects in the double digits. I love Comcast’s diversified business model, offering investors exposure to the pipes as well as the content that flows through them. CMCSA already has the operations in place that AT&T is currently in court fighting for (this is both a positive and a negative for Comcast; I think it gives this media company a competitive advantage in the present, but I also think there are risks that the government gets heavy handed with CMCSA, potentially forcing a break up should AT&T’s acquisition of Time Warner not be allowed). I find Tencent so interesting (and attractive) as an investment because of its holding company nature. When a lot of people think of Tencent that they of social media via WeChat and view it was the Chinese version of Facebook, but I view it as much more than that. Tencent has valuable stakes in many companies in the technology and media spaces, including Tesla, Activision-Blizzard, and newly IPOed Spotify (assuming that TCEHY didn’t liquidate its shares during the recent listing process). Tencent is oftentimes viewed as an avenue into the Chinese markets and it has the rights to a wide variety of content in the Chinese market. I know many don’t like this seemingly forced business arrangement between China and the rest of the world. I’m not a fan of the market obstructions either, but as an investor, I say don’t hate the player, hate the game. Tencent is a major beneficiary from Chinese government policies at the moment and while I recognize that this could change at the drop of a hat, I don’t think it’s likely and I suspect that Tencent will continue to grow its in-house properties as well as make partnerships and investments in high growth tech/media names that I’m happy to have exposure to. Comcast certainly wins that battle from the dividend growth and valuation perspectives. Tencent isn’t cheap, trading for more than 50x earnings on a ttm basis. However, in a head to head match up, the strength of Tencent’s diversified portfolio and its overall growth potential win out in the end. This was a tough call but Tencent is a global leader in a handful of my favorite secular growth markets (gaming, digital media, mobile payments, etc) and because of this, it advances to the Elite Eight.

2 NVDA vs. 3 AMZN

This is probably the most interesting match up of the Sweet Sixteen, in my opinion. Both Amazon and NVIDIA have been amongst the fastest growing stocks in the market in recent years regarding total returns. What’s more, these two companies arguably occupy the two leading positions in the AI race that is poised to be a generational growth market. Both stocks are very expensive; however, using traditional price/earnings, NVDA takes the cake here with its 36x forward P/E ratio versus AMZN’s 170x forward P/E. NVDA pays a growing dividend, but because of its extremely low yield (0.27%), it’s going to take decades (or a massive sell-off) for income to play a significant role in an investment thesis involving NVIDIA. Honestly, I’m not going to spend a whole lot of time breaking down these two companies because I freely admit that my investments in both companies are based upon future speculation. I think both names have fabulous growth potential, which makes picking between the two of them a relative toss up. At the end of the day, I decided to go with AMZN because of its more diversified business model. While NVDA offers best in class chips and software programing in the gaming/AI/automotive arena, AMZN offers exposure to this market (though to a lessor extent) while giving investors exposure to eCommerce, cloud, and a variety of hardware offerings in high growth areas such as IoT (connected homes) and digital personal assistants. When I’m speculating I like to spread my bets around a bit, and AMZN allows this on a relative basis.

1 GOOGL vs. 4 BRK.B

Earlier, when discussing Tencent, I spoke about my bullish stance on holding companies. Well, here we have a heads up battle against two of the world’s best. Berkshire Hathaway is a well known financial/retail/industrial conglomerate built on value oriented principles while Alphabet has structured itself into a technology holding company headlined by the cash cow Google properties that support M&A and R&D in numerous high growth areas. Berkshire is one of my favorite defensive holdings due to its cash flow generation and the large cash pool that Buffett and crew have amassed in the recent past, looking to make a deal at attractive valuations. In a rising rate environment, I suspect that Berkshire’s high exposure to the financial sector could be a boon for the company’s bottom line. Berkshire is certainly more diversified than Alphabet, operating across numerous sectors/industries while the Silicon Valley superpower is more much focused on digital advertising and disruptive tech; however, while Berkshire’s properties have shown a proclivity for profitability, many are viewed as somewhat old fashioned. Looking ahead into the 21st century, it appears that Alphabet’s assets might be better suited for growth. Sure, they come with less certainty and more risk; however, I’ve been impressed with recent capital discipline and I think that this management team is responsibly focused on profitably generating long-term growth. I’ve been pleased to see Alphabet’s “other bets” category produce attractive assets such as Waymo, which appears to have a chance to become the leading competitor in the very attractive driverless vehicle market. I’m happy with GOOGL’s advances in AI and cloud technologies. And while GOOGL doesn’t have quite as much cash on hand to make accretive investments as Berkshire does, it still has nearly $100b dollars on the balance sheet and this gives me peace of mind as an investor. Needless to say, I’m very bullish on GOOGL’s long-term growth prospects, but right now I’m in a more risk-off investment mindset, and I’d side with Berkshire as a late cycle investment. This was a close call and if GOOGL was a tad bit cheaper I might have gone the other direction, but because of a combination of micro and macro headwinds facing GOOGL, BRK.B is the winner is a hard fought match.

2 BA vs. 6 FDX

We have a pretty interesting match up here to send the Sweet Sixteen between two of the leaders in the transports sector. Both of these companies benefit from the secular growth trend that boosts the aerospace sector. Boeing operates in duopoly with Airbus when it comes to manufacturing planes and FedEx is one of the global logistics leaders. Boeing is facing trade related headwinds at the moment and there is speculation that a burgeoning Chinese plane market will hurt long-term growth. Investors fear that FedEx is in the crosshairs of Amazon as that disruptive company looks to cut cost in the shipping arena. Both of these companies offer investors wide moats, though I think that Boeing wins in this regard. Both companies are priced above their historical averages on the ttm basis, yet they’re also both major beneficiaries from tax reform, pushing forward P/E’s way down. FDX is currently projected by analysts to earn ~$15/share in 2018, meaning it’s trading for less than 16x forward earnings. Boeing is expected to earn ~$14.20/share in 2018, meaning that it’s currently trading with a ~23x forward multiple, giving FedEx the edge when it comes to valuation. Both companies offer strong, double digit growth prospects, but Boeing’s dividend yield is significantly higher than FDX’s, so BA wins in terms of the dividend. Over the past 5 years or so, BA has reduced its outstanding share count by 21.4%. Over that same period of time, FDX has reduced its outstanding share count by 14.2%, which is very impressive in its own right, but doesn’t quite stack up to BA’s results. Throughout this tournament I’ve typically favored valuation to growth with the exception of a couple of powerful teams whose growth was too much to ignore. Well, Boeing falls into this latter category. FedEx’s valuation is enticing, but Boeing’s strong market position, the increased cash flows I expect to see from its growing service division, and its tremendous shareholder returns pushed it past its aerospace compadre, FedEx, into the Elite Eight for a another block buster industrial match up against Berkshire.

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